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Mean-Variance portfolio optimization attracted lots of attention in this forum so far. I am interested in the effect of incorporating transaction costs into the decision framework and I would like to obtain 'optimal' portfolios. In other words, approaches which are still capable of being solved using quadratic programing by constraining maximum turnover are not what I am looking for. Just recently, this question was solved with the help of the community in order to obtain optimal portfolios if we consider quadratic transaction costs. However, what happens if we come up with transaction costs in a V-shape, which means we pay a fee proportionally to the sum of absolute rebalancing: $$TC(\omega_\text{new}) \propto ||\omega_\text{new}-\omega_\text{old}||.$$ This (rather old) paper by Atsushi Yoshimoto handles exactly the optimization problem I want to solve: $$ \omega_\text{new} = \arg\max {\omega'\mu - \sum_{i=1}^N c_i -\lambda \omega'\Sigma\omega} \\ \text{s.t.} c_i = k(d^+ _{i,t} + d^- _{i,t}), \forall i \\ \omega_{i}-\omega_{old} = d_{i} ^+ - d_{i} ^-, \forall i \\ d_i ^+ d_i ^- =0, \forall i \\ d_i ^+, d_i ^- \geq 0 \forall i \\\omega'\iota=1 $$ Intuitively speaking the optimization is doing the following: Given estimates of future returns $\mu$ and volatility $\Sigma$, we search for $\omega$ which maximizes our Certainty equivalent. This value is decreased with total transaction costs $\sum c$. Transaction costs occur if we rebalance our portfolio: Given we increase the share of wealth in one asset $i$, this affects $d_i ^+$ and, vice versa, if we decrease the share of wealth in one asset, this increases $d_i ^-$. Total rebalancing in asset $i$ is therefore $d_i ^+ +d_i ^-$. The constraint $d_i ^+ d_i ^- = 0$ ensures, that one cannot buy and sell simultaneously one asset (which should be clear). The last constraint requires that our new portfolio weights $\omega$ sum up to 1, therefore we are investing all the money into the available assets (I did not incorporate an additional short sell constraint here, opposed to Yoshimoto).

I would love to implement this optimization in R, Matlab, Python, whatever, but I do not understand the structure explained in this paper: All which is explained is that a nonlinear optimizer called GAMS/MINOS was used. I think, 20 Years after publishing there should certainly be a publicly available approach to to this, therefore I ask (i) does an implementation already exist? (ii) If not, how to do this properly?

EDIT: To show my first approach I worked out this small example for R. Hereby I neglect the estimation of the mean but only consider volatility timing:

library(alabama)
library(quantmod)

symbols <- c("MSFT","AAPL","MMM")            
getSymbols(symbols,src='yahoo',from = '1995-01-01') 
N <- length(symbols)

MSFT <-  to.monthly(MSFT)
AAPL <-  to.monthly(AAPL)
MMM <-  to.monthly(MMM)
returns <- data.frame(MSFT=diff(log(MSFT$MSFT.Adjusted)),
                  AAPL=diff(log(AAPL$AAPL.Adjusted)),
                  MMM=diff(log(MMM$MMM.Adjusted)))
returns <- na.omit(returns)
names(returns) <- symbols

mu <- rep(1,N)
sigma <- cov(returns)
lambda <- 4
costpara <- 50/10000
wold <- rep(1/N,N) 

fn <- function(w) -w%*%mu + costpara*sum(abs(w-    wold))+lambda*t(w)%*%sigma%*%w
heq <- function(w) return(sum(w)-1)
out <- constrOptim.nl(par=wold, fn=fn,heq=heq)
rbind(out$par,wold)

wnew 0.3333233 0.08347908 0.5831977
wold 0.3333333 0.33333333 0.3333333

However, I am not too familiar with numerical optimization, so can anyone confirm this approach is correct, or point out ways to improve the optimization?

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What you do looks ok. But in practice how would you set costpara? This coud have a huge impact on your optimization.

So I would do something different. Define the buys $b_i>0$ and the sells $s_i>0$ then you have $$ w_i = wold_i + b_i - s_i $$ or in other terms: $$ w_i-wold_i - b_i + s_i = 0. $$ This is a linear equality that you cas use in your heq. Then you add a constraint $$ \sum_{i=1}^n b_i + s_i \le T $$ for some turnover limit $T$. Then you make sure that the problem is optimized under a turnover constraint. Multipliying this $T$ by your cost of one percent sold or bought gives you control over transaction costs.

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  • $\begingroup$ Thanks @Richard for this additional remark! However, by applying this approach I simply shift the problem of handling costpara towards handling an appropriate choice of the threshold T, no? However, I like this feature as it also implies a threshold on the maximum transaction costs I am willing to pay! $\endgroup$ – muffin1974 Nov 10 '16 at 13:51
  • $\begingroup$ Right, but isn't it clearer in the constraint than in the objective? In the constraint you say: the change of the positioning must not cost more than x. This is clearer to me than mixing risk, expected return and turnover in the objective. $\endgroup$ – Richard Nov 10 '16 at 14:16
  • $\begingroup$ Thanks! Well, I agree that it may seem more elegant, however, if transaction costs matter I think they should be taken into consideration. By restricting turnover I avoid allocations at points which are too costly, but nothing is said whether it is really worth to reallocate within this restricted region. Incorporating transaction costs into the objective simply maximizes the CE net of rebalancing costs, which I think is a reasonable approach. $\endgroup$ – muffin1974 Nov 10 '16 at 14:42
  • $\begingroup$ Ok, now I understand: your costpara is not just some penalty but exactly the cost. I agree that this makes perfect sense. $\endgroup$ – Richard Nov 11 '16 at 7:30

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